Selection Criteria

So, the state of play is: I have a list of 583 shares from which I want to pick 12. I’m hoping Chapter 13 of “The Motley Fool Investment Guide” will get me down to a short list from which I can pick the 12 . The chapter presents a list of eight criteria that are geared towards finding growing small-cap companies. The criteria are:

1. The company’s sales are $500m or less.
In the US this is considered a small company. The rational for investing in small companies is that there are more likely to grow than large companies. I’m pretty sure that would not be a small company in Australia, but I don’t know what threshold to use, so I will leave if at $500m for now.

2. Daily Dollar Volume: From $1m to $25m.
This is the value of trades done each day. Volume is usually quoted in number of shares, so I will estimate this by multiplying the number of shares by the closing price. Again, I don’t know whether this range is too high for Australian markets.

This criterion is about liquidity, ie how easily you can buy and sell a share. Given its Christmas at the moment, an extraordinary number of companies are not trading at all. I don’t want to be left holding something I can’t sell if I need to, but given I don’t have much to invest I will set a lower threshold of $100,000 (still many times more than any trade I would be doing).

3. Minimum Share Price of $7.
In the US, the share price for one share can be thousands of dollars. In Australia, the average share price is $1.66 (I calculated this by excluding options etc from the “Weekly Round Up – Sector by Sector” table for 9 January 2008. This table is available on the AFR website http://afr.com/home/tables.aspx). The Motley Fools cut out at $7 because shares priced this low in the US are generally illiquid. I’m inclined to think this is double counting. The Daily Dollar Volume is an accurate measure of liquidity and this is some strange proxy, so I’m not going to try and set a minimum share price for Australian shares.


4. Net Profit Margin: At Least 7%.
This is a measure of quality. It is the bottom line of the profit and loss statement (ie “Net Profit”) divided by the top line (ie “Sales” or “Revenue”). The Fools reckon 7% is a high number which indicates that the company is “soundly beating its competition or (Fool’s Choice) has no competition at all”. I have no idea whether this is a good figure for Australian companies, so in the absence of any available evidence, I’m just going to take the 7% at face value.

5. Relative Strength: 90 or Higher.
Relative strength is a rating of how a share has performed relative to all the other shares. The range goes from 1 to 99. A relative strength of 90 indicates that the share has outperformed (is that a real word?) 90% of all the other shares. The idea here is that shares will have a high relative strength because they “(1) are doing something right and (2) have the market taking notice.”

Relative Strength is not a figure you often see quoted in Australia. The only place I have seen it is at the end of news articles on www.businessspectator.com.au. This is not at all helpful if I’m looking up a share that hasn’t had any articles written about it.

Annoyingly, the book does not explain how to calculate Relative Strenghth, but as a proxy, I’m going to do my own calculation using the “Weekly Round Up – Sector by Sector” table. I’m going to rank the shares by closing price on 9 Jan 2008 and divide by the 52-week low. Anything that is not in the top 10% will get the heave-ho.

This is not perfect because it will mean that every share's return is calculated on a different time period. A company that has taken 12 months to achieve a return of 10% will be rated the same as a company that has taken 1 day to achieve a return of 10%, but we will just have to bear this in mind for now.


6. Earnings and Sales Growth: 25% or Greater.
So again we are looking at the top line and the bottom line of the profit and loss statement. This time to see whether the change in both is an increase of 25% from the year before. 25% sounds a lot to me, particularly with the way the economy is going, but I’ll stick with it for now.

7. Insider Holdings: 10% or more.
The idea here is that if the people managing the company also own the company, they will be very interested in making sure it does well. Sounds reasonable to me, but 10%? Again, I don't know if this is reasonable or not, so I'll just take it on face value.


8. Cashflow from operations: a positive number.
This figures appears on a company’s cashflow statement. Having it positive means that the company is being paid more from its customers then it is paying its suppliers and staff. This sounds like profit, doesn’t it? However, I’m reminded of a quip I heard about Centro “its business was great, but its debt was greater”. So, while its not a guarantee of a solid company, I still think it’s a good criterion.

So, to sum up, here are the criteria I’m going to use to get my long list down to a short list:

1. Daily Dollar Volume: From $100,000 to $25m.
2. My Relative Strength Proxy: 90 or Higher
3. Net Profit Margin: At Least 7%.
4. Cashflow from operations: a positive number
5. Earnings and Sales Growth: 25% or Greater
6. Insider Holdings: 10% or more
7. The company’s sales are $500m or less.

I’ve rearranged the order a bit, as the first two will cut out the most shares. The remainder requires downloading annual reports and I've put those I'm more sure about first.

Next post, I’ll put all this all into action.